Rick Van Valkenburgh, CPA, is a Tax Partner with Larson & Company. He specializes in tax planning and preparation for small businesses and fast-growing companies.

What is an estate?

When a person is born in the United States of America, that new person is assigned a Social Security Number and is officially “in the system”.  Throughout life, that person may acquire assets in the form of money and property.  These assets make up the estate of that person and, when that person dies, the estate remains as an entity that may be subject to taxes in the place of the deceased.

What is estate tax?

Under current tax law, the estate will be subject to estate tax at the time of death if the estate exceeds the lifetime exemption for estates.  In 2020, the lifetime exemption for a single person was $11.58 million and $23.16 million for a married couple.  Those amounts increased in 2021 to $11.7 million and $23.4 million, respectively.  This estate tax is intended to prevent wealthy individuals from transferring their estate to their posterity, tax free.

What is gift tax?

What many people often don’t understand is that the potential tax on gifts given belongs to the giver, not the recipient, but only if the total value of the gifts given by a single giver to a single recipient exceeds the annual gift limit, which is $15,000 for 2018 through 2021.  When a person gives a gift in excess of the annual gift limit, that person must file a gift tax return and choose to either pay a tax on the gift or reduce their lifetime exemption by the amount of the gift in excess of the annual gift limit.

One simple strategy for married couples wanting to gift more than annual gift in a year to an individual without the requirement to file a gift tax return is to have each spouse gift the annual limit to that individual.  In 2021, this would increase a potential gift amount of $15,000 from an individual to another individual to $30,000 from a married couple to an individual.  If a married couple would like to gift the maximum to a married child and spouse, they could gift up to $60,000, if done properly, without being required to file a gift tax return.

Click here for FAQs on Gift Taxes at irs.gov

What is an inheritance and how does it differ from a gift?

An inheritance occurs at the death of an individual who assigns their estate to a beneficiary.  Beneficiaries are often surviving spouses or children.  In some states, spouses are often considered to each own half of the married couples’ assets and income.  If one spouse dies, the other spouse automatically retains their half ownership in the assets and income.  The other half could then be assigned to the surviving spouse or to others as determined by the decedent prior to death by the use of a will.

When an individual inherits assets from a deceased individual, whether or not any tax will be owed on that inheritance depends on a number of different factors.  The most common factor, though, is the Fair Market Value (FMV) of the asset compared to its basis.  In most cases, the tax on inherited items is determined by the difference between FMV and basis, which is often $0.

Basis: The basis of an asset is calculated by adding to the purchase price of the asset any increases, repairs, improvements, additional invested money in the asset, etc.  Any depreciation must be subtracted from the basis.

Basis of a Gift:  Under current tax laws, the recipient of a gift assumes the giver’s basis in that asset.

Basis of an inheritance:  Under current tax laws, the beneficiary that inherits an asset generally gets basis in that asset based on its Fair Market Value (FMV) at the time of death of the individual passing on the inherited asset

For tax planning purposes, it is almost always better to receive an asset by way of inheritance rather than as a gift.


A cautionary tale

An elderly widow, we’ll call her Anne, presented a predicament to her CPA.  She sold a piece of property in another state.  At tax time, she took her tax papers to her CPA to prepare her income tax return.  She told her CPA she inherited this property from her parents several years ago.  The CPA requested additional information to determine the cost basis at the time of inheritance in order to determine the taxable gain on the sale.  After much probing, the following situation came to light:

Anne and her late husband, John helped Anne’s elderly parents manage their finances in the early 2000s.  Her parents had established a trust a few years prior but didn’t actually transfer any of the assets to the trust.  Anne’s father passed away and a few years later, her mother also passed away.  Before her passing, Anne’s mother was diagnosed with a terminal illness.  In an innocent effort to settle affairs before her passing and avoid probate, she quit claimed the deed to her home, which was one of the most valuable assets in her estate, to Anne and John.  She didn’t understand how the trust worked or how inheritances were better than gifts for tax purposes, and neither did Anne nor John.  It was intended that Anne and her brother would jointly own the “inherited” home.  They held onto the home and began renting it out.

A few years later, the home, which was now an income-producing rental property, needed repairs.  Anne’s nephew, her brother’s son, was a handyman and wanted to earn extra money by doing the repairs himself.  He didn’t have a contractor’s license so, in order to bypass the state’s requirement for the work to be done by a contractor, they added the nephew to the deed without considering the potential tax implications for doing so.  They also thought it would be a good idea to have someone from her brother’s family listed on the title.

A few more years went by, and the family decided to sell the home.  At closing, the title company, after paying all the realtor fees and closing costs, divided the proceeds evenly between Anne and her nephew.  Anne knew she would need to pay taxes on the transaction but hoped it wouldn’t be too much.

The bottom line, Anne and her nephew paid tens of thousands more in income tax because of the mistakes that were made with this property.  While there were many mistakes made along the way, there are a few simple things that could have been done to save taxes:

  • Properly transfer Anne’s parents’ assets to the trust before both of them die
    • Anne didn’t know for sure but she thinks her parents bought the home in the 1970s for about $40,000
    • Because the property was transferred to Anne before the death of her terminally ill mother and not transferred to the trust, it was treated as a gift instead of an inheritance, making Anne’s basis in the property $40,000
    • The Fair Market Value of the home at the time of Anne’s mother’s passing was about $450,000, which would have been the trust’s basis had the property been properly transferred to the trust
      • A gift tax return should have been filed to report the $40,000 gift to Anne and the lifetime exemption reduced for Anne’s mother
    • The home was eventually sold for $750,000
      • Selling expenses were $53,000
      • Because the home was gifted to Anne and she gifted half to her nephew, their combined taxable gain was $657,500
        • A gift tax return should have been filed to report the $300,000 gift to Anne’s nephew and the lifetime exemption reduced for Anne
      • If the home had been properly transferred to the trust, their combined taxable gain would have been $247,000
      • This error caused the combined federal and state taxes for Anne and her nephew to be about $60,000 more than it would have been if the home had been properly transferred into the trust


What is a trust?

From Investopedia.com: A trust is a fiduciary relationship in which one party, known as a trustor, gives another party, the trustee, the right to hold title to property or assets for the benefit of a third party, the beneficiary. Trusts are established to provide legal protection for the trustor’s assets, to make sure those assets are distributed according to the wishes of the trustor, and to save time, reduce paperwork and, in some cases, avoid or reduce inheritance or estate taxes.

Creating a trust allows the trustor to transfer all of his/her assets to the trust.  When that individual dies, he/she personally owns no assets, thus avoiding probate.  Instead, the trust steps into the shoes of the decedent and the distribution of the trust assets are done according to the trust document and laws of the state in which the assets are located.

What is probate?

From Investopedia.com: Probate is the term for a legal process in which a will is reviewed to determine whether it is valid and authentic. Probate also refers to the general administering of a deceased person’s will or the estate of a deceased person without a will.

State laws govern probate requirements.  It is important to know whether a probate is required following the death of an individual. The probate process can take a long time to finalize. The more complex or contested the estate is, the more time it will take to settle and distribute the assets. The longer the duration, the higher the cost.

Probating an estate without a will is typically costlier than probating one with a valid will. However, the time and cost required of each are still high. Also, since the proceedings of a probate court are publicly recorded, avoiding probate would ensure that all settlements are done privately.

Some assets can bypass probate because beneficiaries have been initiated through contractual terms. Pension plans, life insurance proceeds, 401k plans, medical savings accounts, and individual retirement accounts (IRA) that have designated beneficiaries will not need to be probated. Likewise, assets jointly owned with a right of survivorship can bypass the probate process.


For more assistance with estate tax issues, contact your Larson advisor today.